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Quarterly Letter to Clients

April, 2015

Indices at quarter-end (March 31, 2015):

Dow Jones Industrials: 17,776.12 1Q'15 -0.26% YTD -0.26%

Standard & Poor's 500: 2,067.89 1Q'15 +0.44% YTD +0.44%

Markets are a psychological phenomenon. The human condition of fear and greed will carry any market to extremes in both directions at some point. Greed forces prices higher, often to unsustainable levels, while fear drives prices down, sometimes to ridiculous depths.

This is true of all markets--stocks, bonds, commodities, real estate, whatever. When the move is extreme to the upside, we call it a bubble. On the downside we call it a crash or, if less severe, a correction. When a bubble bursts the collapse is immediate and dramatic; the recovery that follows often takes years.

While recoveries are usually slower, they are more persistent. In 1929 stocks reached a high that would take 25 years to re-attain. In 1967 the Dow Jones hit 1000 for the first time; it would not move definitively through that level again until 1982. This past quarter the NASDAQ index crossed 5000, a level it had not seen since 1999.

Stocks in general, as measured by the Dow Jones and the S&P 500, saw new all-time highs during the last three months, while the NASDAQ came very close. It doesn't feel euphoric, though, and it is certainly not a bubble. Rather, it feels like we are struggling to hold on to current levels. It is problematic to see up or down moves of 300 or more Dow points in a given day. Every time you think the market has defined a direction, it reverses, often the following session.

One source of pressure on both the stock and bond markets is interest rates. It is widely assumed that the Fed will raise interest rates in either June or September of this year. It is further assumed that the rise will be one-quarter of one percentage point, 25 basis points, about as small a bump as possible. What is important, however, is not the size of the move, but rather the action of a reversal in the direction of rates.

Low interest rates have been a boon to corporate America, and a tailwind to stocks and bonds. If rates go up, and companies have to pay more for capital, it stands to reason that earnings will be impacted. So the Fed has promised it will not raise rates until it is certain that the economy can withstand such a move.

And it appears that the U. S. economy is, indeed, robust enough for a boost in rates.

There are a number of positive factors in the economy, including employment, oil prices, the strong dollar, and low commodity prices. Inflation seems tightly contained, maybe too much so.

We humans have short memories. With the Euro trading recently as low as $1.05, versus it's year-ago price of around $1.40, we might forget that only around five years ago the dollar was the currency moving down. We might not recall that during the last ten years oil went from $45 to $140, back to $45, then back over $100, and only a few weeks ago traded once again below $45.

We can be forgiven for forgetting that interest rates move in cycles of three to four decades. While 2008 may still be fresh in our minds, we might not remember the stock market breaks of 1973-1974, 1987, 2000-2002. What we should not forget, though, is that stocks have always recovered.

But enough of history: what, we want to know, is going to happen to markets in the near future.

Bonds are almost certainly as high as they can go, and interest rates should soon enter a new long-term upward cycle, probably very gradually at the beginning. Thus, we can expect that bond prices will move lower, slowly at first, but persistently. We have shortened maturities in order to soften the effect, but all bond owners will certainly be impacted. If the bond market is a bubble, and in the eye of history it may well be, it is not one that will burst, but rather one that will melt away.

I am not of the opinion that stocks are priced too high, but they certainly are not cheap. After six consecutive years of gains no one should be surprised if equities back off. I believe in buying stocks for the long term, and I believe that the best time to buy them is when the market is down. How far down is subjective. In theory at least, "we'll know it when we see it." One must look back on the various market breaks in our history and examine what happened in the following years. If you do that, it will be easier for you to buy when everyone else is selling.

I am not predicting or expecting a market break in stocks. Rather, I am of the opinion that the players are more sophisticated, and everyone now "knows" that it is right to buy on the dips and breaks; that knowledge itself smoothes the curves and lengthens the time between actual bubbles. I am also aware that simply possessing this knowledge does not make it easier to buy when stocks are tumbling.

But stocks are not tumbling, nor are bonds, and we must continue to look for value, growth, and yield in the markets that confront us today. It is a challenge we will strive to meet.

Jim Pappas